Crude indicators for dollar’s dominance

Ingvild Borgen is a rates and FX analyst and Kelly Chen is an economist at DNB Markets.

Ray Dalio has a rare gift when it comes to understanding both the minutiae and grand sweep of economic developments. But he has a blind spot when it comes to the Chinese renminbi.

The Bridgewater founder earlier this year argued that the Chinese renminbi is becoming increasingly international and is threatening the American dollar’s global supremacy. While the former might be true, the latter is a stretch. A big one.

The best illustration of the US dollar’s unique status is arguably the global market for oil trading. Most of the trade is denominated in US dollars, even when neither the barrels of crude nor the parties trading it have anything to do with the US.

It’s therefore understandable that China starting to pay for oil in renminbi is often seen as a big step towards a more ‘multipolar’ international monetary system, where the US dollar loses ground to the Chinese renminbi. CNN’s Fareed Zakaria is the latest pontificator to highlight this.

However, the increased importance of the Chinese renminbi in global oil trade is massively overstated.

When trading oil — as with most commodities — hedging is key. In 2022, the daily average of traded volumes and open interest in the primary global crude oil futures markets were above 7bn barrels. That’s about 88 times the daily global crude oil output. The ‘multiplier’ of global crude oil output to the crude oil futures markets is thus 88.

China wants to purchase more oil in renminbi and indeed, needs to purchase oil denominated in something other than US dollars, as some important suppliers (Iran, Venezuela and Russia) are sanctioned by the US. China set up its own commodity exchange in Shanghai — the Shanghai International Energy Exchange (INE) — in 2018, for oil futures contracts settled in renminbi with physical delivery.

The contracts traded there are denominated solely in the Chinese renminbi, while all other contracts traded globally are denominated in US dollars. However, the sums traded in Shanghai remain pretty small.

In the last three months of 2022, daily average traded volumes and open interest contracts of crude oil futures on INE was the equivalent of 333mn barrels.

For comparison, Brent and WTI crude oil contracts traded on the ICE and NYMEX averaged almost 6bn barrels in the same period. As a share of total trade, Shanghai accounted for 5.1 per cent.

Moreover, this share has only increased marginally since activity on the exchange started in earnest in late 2018.

In December China asked more of its suppliers — not only those sanctioned by the US — to settle trades in Shanghai and to accept payment in renminbi. A potential deal between China and Saudi Arabia also captured some attention late last year. That’s understandable, given that a deal between the world’s largest oil exporter and the single biggest importer could potentially could involve large volumes settled in renminbi instead of US dollars. But does it actually move the needle?

Nothing has been agreed formally, but even if we assume that around 1/3 of the approximately 1.5mn barrels per day of Saudi Arabian exports to China are settled in renminbi, this would imply an additional 0.5mn barrels per day traded directly on the Shanghai exchange. The direct impact is minimal considering the daily average traded volumes on the exchange was 245mn barrels in the fourth quarter of 2022.

Exports from Saudi Arabia are often sold under term contracts, with regular flows of agreed volumes, and — importantly — at a price which is largely priced off the US dollar-denominated Brent benchmark. Ultimately, pricing risk therefore remains largely linked to Brent, and physical volumes settled in renminbi are unlikely to trigger a major shift in the participation in the financial futures markets.

Assuming for simplicity that the increase in renminbi-denominated futures contracts traded would increase in line with the global multiplier of 88, this would entail an increase of 44mn barrels. All else equal, the volumes traded in Shanghai would then account for 5.8 per cent of the global total, instead of the current 5.1 per cent.

The crazytown scenario

Let’s be unrealistic for a second and assume that Saudi Arabia agrees to accept payments in renminbi for all of the oil it sells to China. Even if it did — and the volumes traded in the renminbi futures market increased by 88 times that much — Shanghai would still only account for 7.1 per cent of the global total.

Taking it an even bigger step further, let’s assume that all of China’s oil imports are settled in renminbi. This would (based on the same assumptions) result in the share of renminbi-based oil futures contracts rising to 15-20 per cent of the global total. The remainder would still be denominated in US dollars.

These back-of-the-envelope calculations show how even in an extreme scenario where China purchases all of its oil in renminbi, the US dollar would still be dominant in oil trading.

These calculations have assumed a multiplier of 88 from the physical oil settlements in renminbi and the resulting increase in futures trading at Shanghai’s INE. For the international benchmark Brent, this multiplier is in the order of 1000s, meaning the volumes traded in the futures market is more than 1000 times as large as the physical trade underpinning the Brent benchmark.

How big the multiplier could potentially be for renminbi settlements in Shanghai takes us back to the core question. It depends on whether a new, international crude oil benchmark contract — based on renminbi and traded in Shanghai — could emerge and challenge the current international Brent benchmark denominated in US dollars.

If it did, the multiplier could be a lot higher, and trading in renminbi-based futures contract could account for a far larger share of the total. But as long as there’s no renminbi denominated benchmark it will not.

China cannot “internationalise” its currency simply by paying for all of its oil imports in renminbi. It has to convince third parties to trade in renminbi as well. Even if more Russian barrels are settled in renminbi, this wouldn’t make the INE a global crude oil benchmark either.

This is a far more difficult achievement, which depends on much more complex issues than China’s share of total oil imports globally. People may periodically be unhappy with the dollar’s dominance and the power it grants Washington, but would they really feel any safer with the renminbi?